optimal monetary policy - bu.edu
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Optimal monetary policy and the Nobel Prize of 2011
Thomas J. Sargent
Contributions• RE models
– Theory– Combined with VAR models as approach to “Interpreting Economic
Time Seies”• Recursive equilibrium methods
– applications of dynamic programming to macro and contract design• Sustantive
– Price level indeterminany under interest rate rules (with Neil Wallace)
– Ends of Four Big Inflations– Rise and Fall of US inflation– European Unemployment
Christopher A. Sims
Contributions• Time series econometrics
– Granger causality (money and output)– Vector autoregressions (money, interest rates, inflation and output– Bayesian methods
• Theory – Rational Inattention– Fiscal theory of the price level
Lars P. Hansen
Student and collaborator• Generalized Method of
Moments– Developed based on a
suggestion in Sims’ Minnesota lectures
• Applied to nonlinear RE models (generalization of Hall)
• Methods in collaboration with Sargent– Rational expectations models– Dynamic policy design with a
concern for “Robustness”
Frank Smets
• Student of Sims at Yale• Developer with Raf Wouters of
one of the key early DSGE models (Europe, then US)
• Estimated using Bayesian methods and competitive with VAR forecasting models
• Head of research at ECB• SW model available in Dynare,
in which models are solved using methods of Sargent and, more closely, Sims
Outline
• Hybrid GG model• Solution a la Sargent• Approximate solution using VAR expectations• Later lab will do solution a la Sims using Dynare• Implications of neutral solution for inflation• Optimal policy with commitment (Phelps, former Nobel prize, with roots to Ramsey).
• Optimal policy without commitment (Kydlandand Prescott, former Nobel prize)
GG “Inflation dynamics”
• Hybrid model: Forward and backward parts of inflation (just like labor demand in Sargent “Black” textbook in 1978).
• What can one do?– Solve it using RE – Estimate it using GMM– Simulate it using
• A full model solution that has a restricted VAR form (this is what is done by Smets and Wouters)
• A single equation that relies on VAR approximations to expectations
Model and solution(s)
• Single equation form
• Sargent solution
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• Sims forecasting approach– VAR– VAR in companion (first order) form
• Applied to forecasting real marginal cost
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Fundamental Inflation
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Reactions
• This is a pretty good inflation model• It is mostly forward‐looking• It can be put in a DSGE framework (and a variant of it is in Smets‐Wouters)
• It can be used to think about monetary policy topics and trade‐offs
Neutral monetary policy• In simplest NK model, zero inflation holds average markup/real marginal cost constant
• Version with residual (interpreted as price shock ‐‐ affects inflation not marginal cost ‐‐SW varying monopoly power).
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Implementing neutral policy (y=y*)
• Nominal rate must be “natural rate of interest” plus expected inflation effect of “time varying (flexible) inflation target”
• Price level indeterminacy must be avoided through interest rate rule
• Review session prep: work through cases with inflation and price level responses
• Requires knowledge and interest rate variability
Optimal policy
• Different visions– Welfare of representative agent– Discounted quadratic costs
• Similar “programs”– Key element is “forward‐looking constraint” represented by PC
– Two stage structure: choose inflation, output gap then find supporting interest rate
• General feature: it is optimal to have inflation initially high and then reduce it through time